In re Trust Under Will of Otto Arens

Decided: January 20, 1964.

IN THE MATTER OF THE TRUST UNDER THE WILL OF OTTO ARENS, FOR THE BENEFIT OF EDITH ARENS HAGEDORN. PLAINFIELD TRUST STATE NATIONAL BANK, SURVIVING SUBSTITUTED TRUSTEE, ETC., PLAINTIFF-RESPONDENT AND CROSS-RESPONDENT,v.MARY LOUISE ARENS WOOLLEY, ETC., ET AL., DEFENDANTS-APPELLANTS AND CROSS-RESPONDENTS, AND JOHN EDWARD ARENS, ET AL., DEFENDANTS-CROSS-RESPONDENTS, AND EDITH ARENS HAGEDORN, DEFENDANT-RESPONDENT AND CROSS-APPELLANT

For modification and remandment -- Chief Justice Weintraub, and Justices Jacobs, Francis, Proctor, Hall and Haneman. Opposed -- None. The opinion of the court was delivered by Hall, J.

This case concerns the matter of treatment, as between principal and income, of distributions with respect to corporate securities held as assets of a trust. Specifically involved are distributions in the form of stock. The fundamental question posed is whether this court should now change the New Jersey common law rule on this subject as applied to trusts created prior to May 9, 1952.

Before that date, this State, in common with many, had followed, with certain local variants, the so-called Pennsylvania rule, named for the state of its origin, absent any indication of contrary intent by the creator of the trust. A radically different principle, first enunciated in Massachusetts and therefore known as the Massachusetts rule, prevailed in a large number of other jurisdictions. Both are, of course, judge-made rules. Broadly phrased, the Massachusetts rule is one of allocation -- an assignment of the whole of a distribution to principal or income, dependent on its form. The Pennsylvania doctrine, on the other hand, is a rule of apportionment between the two accounts based on the extent to which corporate earnings accruing during the period of the trust are utilized as the foundation underlying the distribution, no matter what form it may take. Professor Scott explains the distinction in this language:

"Under the so-called Massachusetts rule cash dividends are treated as income and stock dividends as principal. Under the so-called Pennsylvania rule * * *, it is not the form of the dividend but its source which determines whether and to what extent it is income

or principal. Roughly speaking under this rule such dividends are income if declared out of earnings accruing to the corporation during the period of the trust, but are principal if declared out of earnings accruing prior to the creation of the trust; or, as the rule is commonly stated in Pennsylvania, such dividends are to be treated as income insofar as they do not impair the 'intact value' of the shares at the time of the creation of the trust." (3 Scott, Trusts (2 d ed. 1956) § 236.3, p. 1813.)

On May 9, 1952 chapter 156 of the laws of that year, N.J.S. 3A:14A-1 to 9, inclusive, became effective. That statute generally follows the provisions of section 5 of the Uniform Principal and Income Act, 9B Uniform Laws Annotated 365, 373, which, in turn, adopted the common understanding of the Massachusetts rule. It precisely prescribes the allocation of various kinds of distributions in accordance with their form. However, by express provision, it affected only testamentary trusts and estates where the testator died on or after the effective date and to nontestamentary trusts established on or after that date. N.J.S. 3A:14A-9. Therefore, New Jersey, like New York and one or two other states which also adopted nonretroactive statutes changing the local version of the Pennsylvania rule, has since had two basically opposite rules on the same subject, one applying to trusts in existence prior to the statute and the other controlling those created thereafter.*fn1

The question comes to us in the following context. This is a testamentary trust. The testator died in 1910. His will bequeathed the residue of his estate in trust "to collect and receive all the rents, issues, profits, dividends, interest monies and income" thereon and pay over the "net annual income" derived therefrom to successive life beneficiaries. The first of these, the testator's widow, died in 1920. The current "tenant," to use the terminology of the 1952 statute, N.J.S. 3A:14A-1(f), is his daughter, the cross-appellant Edith Arens Hagedorn. Upon her death the remaining principal is to be distributed. The identity of all those who have a possible interest in that ultimate distribution, the "remaindermen," again using the statutory term, N.J.S. 3A:14A-1(g), was determined by this court in a prior proceeding. Plainfield Trust Co. v. Hagedorn, 28 N.J. 483 (1958). In still earlier litigation it was decided that the language of the will contained no direction or expression of intent as to how distributions on stock held in the trust should be treated. Hagedorn v. Arens, 106 N.J. Eq. 377, 379-380 (Ch. 1930).

In the present action the trustee sought judicial allowance in the Union County Court of an intermediate account of its administration from 1946 to 1959. During that period, both before and after the effective date of the 1952 act, the trustee received some 34 distributions of stock on the securities which it held of ten nationally known corporations. These included true stock splits, distributions designated as stock dividends ranging from 1% to 100% of the outstanding shares of the particular company, and distributions in the form of shares of stock of a corporation other than the declaring corporation. The trustee had provisionally placed all these distributions in the principal account and, in connection with the accounting proceeding, sought the instructions of the court as to how they should be finally assigned. It expressed doubt, not as to the law applicable to pre-1952 trusts by reason of the passage of the statute, but rather with respect to allegedly uncertain aspects of the common law as related to the treatment of several

of the particular distributions. It presented two alternative calculations to the court, under one of which the tenant was entitled to share in the distributions to the extent of $76,027.64 and under the other, $42,360.68.

In the trial court, the remaindermen strongly advanced the view that the New Jersey common law rule should be abandoned as to pre-1952 trusts in favor of the Massachusetts rule, which, as has been said, was essentially followed in the 1952 statute. If that course were followed, substantially all of the items involved would appear to be allocable to principal without apportionment, since they were non-cash distributions. Alternatively, the remaindermen contested many items of apportionment in both of the trustee's calculations as erroneous under proper application of our common law. If these contentions were to be upheld, the tenant's apportioned share might be limited to something under $10,000. The tenant urged the retention of the present common law and insisted that she was entitled to the amount shown by the larger of the trustee's calculations under the correct interpretation of that law.

The proofs at the trial, which lasted several days, were voluminous and intricate. The underlying financial details of each of the distributions involved were examined at length through documentary and expert interpretive evidence. This necessitated delving rather deeply into the complexities of theory and practice in modern corporate finance and accounting. In its opinion, 72 N.J. Super. 310 (Cty. Ct. 1962), the trial court said "* * * that it believes the apportionment rule to be no longer an equitable one and poses serious, and eventually insurmountable, problems in application for fiduciaries, and really is not workable any longer." (at p. 320). The quite proper conclusion was reached, however, that any change could only be made at the appellate level. The judge went on to decide that the trustee's smaller calculation by which $42,360.68 of the total stock distributions was apportioned to the tenant represented the proper application of the

common law rule. The appeal of the remaindermen*fn2 and the cross-appeal of the tenant from the resulting judgment were certified while pending in the Appellate Division.

As we said at the outset, the fundamental question is whether the New Jersey common law rule is now to be discarded entirely. The problem has several facets. The first is whether abandonment is indicated as a matter of sound principle. We believe the answer is strongly affirmative. The second aspect then becomes what the replacement rule should be and whether we can and should make the change, the only effect of which will be upon pre-1952 trusts. Again, we are convinced that we have the power to and should so act. The final query is how a new rule should be made effective and what the result is when applied to the distributions here involved.

Div. 1956), affirmed on other grounds 23 N.J. 205 (1957), and In re Terhune, 50 N.J. Super. 414 (App. Div. 1958), is strongly illustrative of contemporary uncertainty in the application of our rule.*fn3 Complete re-examination was foreshadowed by In re Fera, 26 N.J. 131 (1958), the only case in the field to come before this court in late years, in which we stopped the clock and declined to extend the rule to an aspect which had been included in Pennsylvania. In now undertaking that reappraisal it will be sufficient to recount somewhat broadly, but in a little more detail than already mentioned, the basic theory of the rule and something of the mechanics of its operation in today's corporate world.

The fundamental premise of our rule is two-fold. First, the principal value of stock held in a trust, i.e., the unimpairable interest of the remainderman, is its proportionate share of the corporation's capital and surplus accounts ("intact value") as of the date of acquisition. This date, of course, bears no relation to corporate fiscal periods. Second, the tenant is entitled to all distributions to stockholders grounded in earnings accruing since that date. If the distribution is made from earnings accrued partly before and partly after acquisition, the distribution is apportioned, presumably pro rata, pursuant to a fiction that corporate profits are earned uniformly, day by day, like bond interest. (Apportionment is likewise required as between successive tenants of distributions earned partly during one life estate and partly in a succeeding one. Hagedorn v. Arens, supra, 106 N.J. Eq. 377.*fn4

Since the rule is not dependent upon the form of the distribution, apportionment is theoretically required even as to ordinary or regular cash dividends -- a result never imposed even in Pennsylvania, on the thesis that expediency must outweigh principle because of the small amounts involved and disproportionate difficulties in computation. See 3 Scott, op. cit. supra, § 236.1, p. 1806. Our cases have gone both ways (see 5 N.J. Practice, Id. § 438) and in practice, fiduciaries, quite sensibly, rarely apportion such dividends. So-called extraordinary cash dividends are, however, clearly subject to apportionment and along with the question of determining when such dividends were earned, the involved and unsettled problem of determining when such a distribution is not ordinary also must be met. See 5 N.J. Practice, Id. § 437.

Distributions in stock of the declaring corporation are, of course, apportionable with respect to "intact value" under the rule, but the infinitely more difficult preliminary question -- in this case the prime one -- appears of whether, or how much, the distribution is founded upon earnings and to what extent, in the light of the particular intra-corporate fiscal transfer, that earnings foundation should properly be assigned to income. The source, if not also the purpose, as well as the time of acquisition of that source, has to be ferreted out. Once the ferreting has been done, the New Jersey variant of the Pennsylvania rule gives the tenant, not the stock distribution or a portion of it ...

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